The market for exchange-traded funds, popular stock-market instruments that track all sorts of equity and bond indexes and commodities, is continuing to grow. But some are better investments than others, experts say.
At the end of last month, the number of U.S.-based ETFs reached 1,585 with $1.95 billion in assets from 80 providers on three exchanges, according to the London-based research firm and consultancy ETFGI. That’s up from 1,158 ETFs with $1.299 billion in assets from 35 providers in February 2013.
Unlike mutual funds, which also invest in stocks or bonds, ETFs can be traded throughout the day like equities. Adding to their popularity is the ease to gain exposure to a wide array of indexes or underlying assets, from the broad Standard & Poor’s 500 index to the price of silver.
[Read: 5 Terms Everyone Should Know About Investing.]
With so many new offerings, it’s worth noting there are substantial risks, including size, liquidity and expense issues and the potential for ETF components to underperform.
“Not every ETF is created equal,” says Mike Sorrentino, chief strategist at Global Financial Private Capital, a wealth manager in Florida. “You’ve got to be careful what you’re buying.”
Here are some aspects to consider:
Liquidity. One major ETF concern is liquidity, or how easy it is to buy and sell shares, says Chuck Self, chief investment officer at Wisconsin-based investment manager iSectors.
To check liquidity, Self says investors can look at a fund’s average daily trading volume and the spread, or difference, between bids and offers, The bid-ask spread will be narrower with more liquid funds, says Celia Cazayoux, director of manager strategy at People’s United Wealth Management.
Size. With the biggest ETF themes already taken — such as a number of ETFs that track the S&P 500 — the industry is going for smaller niches, says Self, who says a fund needs about $50 million in assets to be commercially viable.
Sorrentino wants a minimum of $100 million in assets, which he says lessens the risk of the ETF going out of business.
Expense. Once an investor has identified investment themes, “just go out and buy the cheapest and largest ETFs out there,” Sorrentino says.
Although fees have generally declined, many ETFs are still overpriced, Sorrentino says. Broad market exposure should not cost investors more than 0.1 percent, although paying more for targeted exposure or active management is reasonable, he says.
Some specialty sector funds can have fees greater than 0.4 percent, Self says. For actively managed funds, his firm tries to pay less than 1 percent.
Diversification. Sorrentino recalls a bond ETF that had exposure to debt in Puerto Rico, which is struggling to repay billions in loans. Because the weighting wasn’t updated fast enough, the fund kept buying more of the debt, “pouring gasoline on a flame,” Sorrentino says.
[See: 10 Best ETFs for Large-Cap Stock Growth.]
But if a fund is properly diversified, then no single risk should cause too much of a concern.
Having a lot of stocks doesn’t mean a fund is properly diversified, Self says. Investors should make sure the fund isn’t too concentrated in one particular area, he says.
Beware leveraged or inverse ETFs. Leveraged or inverse ETFs use debt to offer multiple times the return of an index, such as the S&P 500, or to short portions of the market. They have been one of the fastest-growing segments of the ETF market, according to Chicago-based investment research firm Morningstar.
But these products were created for traders to hedge risk on a short-term basis and not to be held over long periods of time, Sorrentino says. Volatility can affect returns over the long term.
“As an investor, do not touch these products,” Sorrentino says.
While there are flaws among ETFs, the funds can offer an easier, cost-effective and more liquid option than building a portfolio with individual stocks to invest in a specific theme, Sorrentino says.
Here’s a look at two broad and two specific ETFs to consider:
SPDR S&P 500 ETF Trust (SPY). Cazayoux and Self both like SPY. Cazayoux cites its size, expense, liquidity, representative exposure and how closely it tracks the index. Self says the fund has substantial diversification, liquidity and tax efficiency. It has net assets of $183 billion and a net expense ratio of 0.09 percent, or $9 for each $10,000 invested annually.
iShares Core U.S. Aggregate Bond ETF (AGG). For broad exposure to the bond market, Self likes this ETF, which Morningstar says has net assets of $34.8 billion and a net expense ratio of 0.08 percent compared to the category average of 0.24 percent.
[Read: 5 Reasons to Avoid Penny Stocks at All Costs.]
Vanguard FTSE Emerging Markets ETF (VWO). For emerging market exposure, Cazayoux likes that this ETF’s track record has been around for a while, as well as other factors. It has $35.4 billion in net assets and a net expense ratio of 0.15 percent compared to its category average of 0.58 percent, according to Morningstar.
Technology Select Sector SPDR Fund (XLK). Sorrentino likes this equity ETF as a way to reach the technology sector without having to do individual stock analysis. He says it has plenty of size, liquidity and diversification. It has $13.7 billion in net assets and a net expense ratio of 0.14 percent compared to its category average of 0.53 percent, according to Morningstar.
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Why Not All ETFs Are Created Equal originally appeared on usnews.com
